Adverse selection at every turn

Benjamin Handel’s paper “Adverse Selection and Inertia in Health Insurance Markets: When Nudging Hurts” (forthcoming in the American Economic Review) is fascinating. It’s about two things: (1) “inertia” or status quo bias in selection of health plans and (2) adverse selection that arises due to efforts to overcome that inertia, e.g., helping consumers better understand the cost and benefits of different benefit packages and cost sharing features.

This paper highlights (i) that inertia can be substantial in health insurance markets and (ii) that efforts to improve choices in health insurance markets with consumer inertia should take into account the potential impact on incremental adverse selection. We cleanly identify the extent of inertia by leveraging a panel data set where all consumers must make an active plan choice from a new menu of health plans in one specific year but must deal with inertia in other years. Several model-free preliminary analyses reveal that inertia has a substantial impact on health plan enrollment as the choice environment evolves over time. We estimate a choice model of consumer decision-making under uncertainty to quantify inertia, ex ante health risk distributions, and risk preferences that yields clear evidence of large and heterogeneous inertia. We use this model to study the impact of counterfactual policies that reduce inertia, without differentiating between specific policies. While reducing inertia increases welfare in the naive setting where health plan prices are held fixed, in the setting where health plan premiums adjust as enrollees switch plans reduced inertia leads to incremental adverse selection and a welfare loss. When inertia is reduced by three-quarters, this incremental welfare loss effectively doubles the welfare loss from adverse selection in the observed environment (8.2% of consumer premiums). Though these results are specific to our setting, they illustrate that the interaction between inertia and adverse selection can be quite important, and that policies to improve consumer choices in health insurance markets should consider the potential for incremental risk- based plan selection. [Bold added.]

In English: The difficulty consumers face in appreciating the value of plans and the resistance they exhibit in plan switching has a risk pooling effect. Think of it this way, if everyone could pick the plan that minimizes their cost, more sicker individuals would end up in generous plans with higher premiums and healthier individuals in less generous plans with lower premiums. This is adverse (favorable) selection into the more (less) generous plans. That consumers don’t perfectly identify their costs under each plan and have status quo bias (inertia) undoes some of this selection.

That’s not to say you want to keep people in the dark just for the risk pooling effect. It’s just to point out that there a selection issue that arises as people are better informed and, perhaps, more willing to switch plans on that basis. To the extent that selection can be counteracted through risk-adjustment of subsidies or other mechanisms, it’s not a big deal. But one at least needs to know about the issue to address it. And, it’s a, perhaps surprising, reason why the efforts to inform consumers about health plan options (more here [PDF]) and provide plan selection guidance under the ACA could exacerbate risk selection.

@afrakt

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